Down Payment how much is too much?

Down Payment how much is too much?
This is one of the oldest questions faced when purchasing real estate. The rule of thumb has always been to put down 20% of the purchase price if you can. Of course, if you had more available, then you were advised to increase the amount. The general principle behind a large down payment is that you will have a smaller mortgage and therefore a smaller mortgage payment. While that may be true, the operative question is: does a large down payment make the best use of your money?

In order to address this question, we must first visit a common misconception regarding home equity and its rate of return. No matter how much (or little) equity you have in your house, the rate of return is always the same: zero. This is important to understand because you would not put your hard earned money into a mutual fund that advertises a 0% rate of return, so why put it into your house? It is dead money that provides the same return as it would if you had literally buried it in your backyard or put it under your mattress.

Now you might think: How is that possible? I put down $100,000 on the purchase of a $500,000 home five years ago and it is now worth $600,000. This is a 100% return on my investment of equity. The common mistake most people make is confusing return on equity with the appreciation of real estate values. True, the house went up in value, but you would have realized this gain regardless of whether you had a mortgage on the property. Indeed, you would have realized it even if you had financed the entire purchase. A home’s appreciation in value does not depend upon the size of the down payment. Real estate values go up and down irrespective of the size of down payments and mortgages. Real estate value is a factor of market supply and demand. The analogy is that boats on the bay will rise and fall with the tide no matter how big or small they are.

Let’s tell the tale of two brothers ready to buy their next home Smart Sam and Nervous Nick. Each has $150,000 available to use as a down payment and are buy a $250,000 home. The Nick decides to follow conventional advice and make a big down payment to reduce his monthly mortgage payments. He will only have a $100,000 mortgage. The Sam on the other hand is privy to the smarter way to purchase his home and he only places $50,000 down. He then invests the remaining $100,000 he had available in a long term investment account. The illustration further assumes that both homes will appreciate at 4% over the next 10 years.  It further assumes 6.5% growth on the money invested in long term investments (most indexes average over 10% per year historically).  They both take out an interest only mortgage at 5.5% (this makes the math simple to follow).  Nick will invest the difference in monthly savings into a long term investment as well.  The monthly difference is $390 at 6.5% growth.  Both brothers are in the 15% tax bracket.

TEN YEARS HAVE PASSED
Projected 10 years into the future both homes will appreciate to the same value of $370,061. Remember, the value increases or decreases based upon market demand. It has nothing to do with the size of the mortgage or the amount of equity in a home. If they both then decided to sell, at the closing they would both have the same gain. Nick would pay off his mortgage of $100,000 leaving him with $270,061 from which they will deduct their original down payment of $150,000 leaving them with a gain of $120,061. Sam on the other hand will pay off his $200,000 mortgage leaving him with $170,061 from which he will deduct his original down payment of $50,000 leaving them with a gain of $120,061. As for the long term investments Nick’s account grew to $65,677 ($390 per month for 10 years); Sam’s grew to $191,218 (remember the $100,000 up front lump sum investment).

Nick’s Net Worth $335,738 could pay the house off in 13.50 years

Sam’s Net Worth $361,279 could pay the house off in 10.75 years

As counter intuitive as it seems, this illustration proves that regardless of the size of the down payment, the gain is always the difference between the original purchase price and the future value of the home. After 10 years of the home appreciating at a rate of 4% per year, both homes have gained $120,061 in value despite the different down payments. This analysis demonstrates that home equity has a 0% rate of return. One thing I would like you to think about, you would not put your hard earned money into a mutual fund that advertises a 0% rate of return. Why would you do the same with down-payment funds?

Now that we have illustrated this critical point, let’s get back to the original question: how much should you put down? Don’t put all of your money down on a house, put as much as you need to, so that you are able to afford the payment.